08 October 2020 - Events
In the wake of COVID-19, a great deal of attention has been given to tenants with existing leases, the effect of the pandemic on the validity of those leases, and to whether businesses will begin reassessing their footprints in an environment where both remote working and e-commerce is on the rise. One aspect that has received less attention is the effect of the pandemic on the sublease market.
As tenants in large metropolitan areas are reassessing their space needs, many of them are hitting the brakes on signing leases, or, to the extent they have already taken space, are either putting some of that space on the sublease market or attempting to give it back to their landlords. In recent years, tech and co-working companies have been particularly active in leasing substantial amounts of space in competitive markets such as Manhattan and San Francisco. However, with Google announcing that they will allow employees to work from home through June 2021 and other tech companies likely to follow suit (if they have not already acted), a visible wave of space is now hitting the sublease markets in these hot-spots, which may present an opportunity for businesses which are still committed to establishing a footprint in these markets.
According to brokerage firm Savills, overall demand for office space in the Manhattan market has plummeted in 2020. Second-quarter leasing activity is down 57.8% from activity levels in Q1 and 71.2% year over year. Further, per brokerage firm Newmark Knight Frank, over 500,000 square feet of sublease space has been added to the Manhattan market since March 2020, with an additional 1.2 million square feet expected to hit the market in short order. Co-working companies, such as WeWork, in particular, have also handed back hundreds of thousands of square feet of space to landlords, with more expected in the coming months. Currently, according to Savills, 25% of the available space on the Manhattan market is sublease space, and, if the downturn follows historic norms, that figure may double by the end of 2020. Although Manhattan landlords have been holding firm on rents this past quarter, with the asking price for annual rent holding steady in Q2 at an average of approximately $83 per square foot (down just 1.3% from Q1), all of this activity is expected to have an impact not only on sublease pricing, but also to put pressure on landlords to reduce asking rents for direct leases for the balance of 2020.
San Francisco is experiencing similar activity. According to CBRE, over five million square feet of office space is now offered for sublease, a 40% increase since March. Cushman and Wakefield report that sublease space accounts for 44% of the space currently on the market, a percentage that grows daily. This is the highest percentage for available sublease space since the dot-com crash 20 years ago. Most recently, one large tech user made 250,000 square feet of newly-constructed space available for terms of up to five years. Sublease pricing currently reflects a 10% to 20% discount from the prevailing citywide average new lease price for office space of $84 per square foot.
These trends are expected to continue for the foreseeable future, as businesses continue the “work from home” regime or at best re-open to limited and regulated usage. Oakland and core Silicon Valley markets have not to date experienced as severe an effect as San Francisco.
Consequently, the fall-out from the pandemic presents an opportunity for tenants who are still in the market for office space in traditionally competitive real estate markets. Those tenants who are simply looking to get their feet wet in such markets will have their pick of subleased space, which is often fitted out to a high standard with all the accoutrements and is almost always offered at a discount compared to direct lease space in the same building. Of course, subleasing brings with it some risks – for example, if the sublessor defaults, unless the subtenant has been able to negotiate for certain protections from the prime landlord, the sublease will automatically be deemed terminated as well. However, in practice, a prime landlord is often willing to be accommodating, particularly in a down market, to keep revenue flowing. Regardless, subleasing could be a good fit for tenants who are flexible and/or just looking to test the waters in a given market before committing long-term.
Further, with so much sublease space coming onto the market, sublessors will likely be willing to negotiate favorable terms for subleases (for example, lower fixed rent, longer free rent periods, etc.). Moreover, for those tenants who are still, despite the pandemic and accompanying downturn, committed to taking space on a long-term basis, the reduced demand and glut of sublease space coming onto markets like Manhattan and San Francisco is also likely to grant prospective tenants greater leverage vis a vis landlords with respect to direct leases. Tenants will likely be able to negotiate asking rents downward and also obtain other incentives from landlords, such as larger work allowances, longer free rent periods, caps on operating expense charges, more flexible assignment and sublease rights, more favorable terms for renewal options, etc. Consequently, prospective tenants in these markets would be wise, to the extent they are flexible, to hit the “pause” button on leasing and/or subleasing plans for another month or two, as the landscape in Q3 and Q4 is expected to morph into one that is much more favorable to them.
For more information on this topic, please reach out to your regular Withers attorney or either of the authors of this piece.